Weekly Market Update
Foreword
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From the desk of Our Asset Allocation team, Friday 26th April 2024.
The Cost of Capex
This week we will conduct PIMCO’s annual secular forum, where our investment professionals from around the world gather to discuss global markets and economy and identify trends we believe will have important investment implications – it should be no surprise that artificial intelligence will be a central topic for discussion. AI has potentially transformative powers over the secular horizon, possibly driving productivity to new heights, changing the structure of labor markets and the workforce, accelerating scientific research, and creating new businesses and industries.
Or alternatively, it could turn out to be a disappointment, in which today’s AI algorithms fail to overcome their inability to reason and plan, and remain in their current roles as mid-level coding assistants, summarizers, and generic photo generators. It is impossible right now to know the technology’s true limits, and testing those limits requires enormous capital investment in chips, storage and data centers, networking, cooling, energy, software development, and more. It’s an expensive experiment in which companies hoping to benefit from AI in the future need to take large risks today, and are at the mercy of those providing the tools to run the experiment.
Nowhere was this clash between secular and cyclical clearer than in this week’s earnings: Meta (Facebook) announcedFootnote1 a significant increase in capital expenditure (capex) plans to invest more in AI research, and the stock was sharply punished for itFootnote2. Meanwhile cloud providers like Microsoft and Google, as well as some chipmakers who reported this week, have been rewarded for healthy current earnings, by offering the products and tools required by AI researchers.
It’s notable that Facebook’s researchers are responsible for some of the most significant recent developments in AI techniques (including the open – or free – Llama 3 model released this week, and the Faiss vector store we use in-house), but the open nature of these models and unclear monetization path means that the large research & development costs need to be borne today, in the hopes of a significant payoff sometime in the future. That future payoff must be discounted at today’s higher rates.
Not many companies, or even economies are able to participate in an experiment of this scale and cost: yet another point of U.S. exceptionalism. Even investors cannot be blamed for preferring the relative certainty of the immediate cash flows being earned by the current sellers of “picks and shovels” (developer tools) in the AI gold rush, over the potential beneficiaries in the next phase of AI adoption, which may or may not occur over an unknowable horizon. In our discussion of the potential for AI, we have to consider not only the future impacts of the hoped-for successes in AI, but who will bear the costs and risks of the rocky path along the way. For large companies with firm balance sheets and other sources of cash flow generation, it may be possible to withstand a long period of capex expansion with an uncertain future payoff, but smaller-cap firms may be more challenged.
DMAF is no stranger to this phenomenon, having had meaningful long-term allocations to secular themes, including green electrification, carbon capture, robotics and automation, electric vehicle parts, and paper-based materials. For many companies in these themes, the near-term capex and costs have remained substantial, and despite our focus on stronger balance sheets, it may be a while before they reap the rewards of their own experiments. In addition to our high-quality focus, we are adding to the portfolio exposures to other factors, notably growth, momentum, and value, all of which can offer more near-term rewards. Nevertheless, we look forward to next week’s secular discussions as we turn our minds to the distant future.
Asset Allocation Team
PS: A similar effect is playing out in Japan: the Bank of Japan, seeing an opportunity to exit an extended period of low inflation and achieve a long-term 2% objective, is facing the challenges brought on by being the sole remaining central bank with easy monetary policy. The yen/dollar closing the week beyond 158 can inflict significant near-term costs on people and businesses, but officials seem to believe this trade-off is worthwhile.
How can DMAF benefit investors in today’s uncertain markets?
- Provide optionality
- Enhance returns
- Control risk
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